The U.S. Private Sector: Gaining Traction

Highlights

As the U.S. stock market has set new highs, many observers remain skeptical that the advance can be sustained. They believe it is primarily supported by the Federal Reserve's highly accommodative stance, but see the U.S. economy as being increasingly vulnerable to "fiscal drag."

In our view, the skeptics ignore mounting evidence that the private sector of the economy is on the mend. This is apparent in the improved balance sheet positions and income statements for consumers, corporations and financial institutions. Indeed, private sector demand has expanded at about a 3% annual pace in the past two years, a full percentage point more than the overall economy.

During the months ahead, consumer spending may slow in response to higher payroll taxes and the impact of sequestration. This could trigger a long-awaited pull-back in the market. However, other factors including more rapid jobs growth, improved financial conditions and a recovery in housing should set the stage for stronger overall growth later this year.

What does this imply for the stock market? Our call at the beginning of this year was that the stock market would test record highs this year, but we were unsure if the gains could be sustained. In light of the evidence that the private sector is gaining traction, we now believe the stock market can continue to advance.

What's Behind the Stock Market Surge?

One of the most noteworthy developments this year has been the strong surge in the U.S. stock market, which has sent the Dow Jones Industrial Average to new highs and the S&P 500 to a near-record high. Previously, we thought the market could test its former highs this year, but we did not expect it to happen this quickly, considering that news on the U.S. and global economy has been mixed.

This begs the question of why it is so strong. The most commonly cited explanation is that the Fed's policy of quantitative easing has created incentives for investors to acquire equities and other risk assets. Nonetheless, while this is part of the story, it is not the full story.

The other major force at play is that the private sector of the economy – consisting of households, businesses and financial institutions – is performing better than the overall economy. Real GDP growth, for example, has averaged about 2% per annum since recovery began in mid-2009, while the private sector has been growing at about a 3% rate in the past two years. Should this pace be maintained the economy is capable of sustaining overall growth of 2% even in the face of so-called "fiscal drag."

Growing Evidence of an Improving Economy

Following is some of evidence that supports the view the economy is gaining traction:

Household balance sheets are improving whether measured by the ratio of debt to disposable income or of debt service payments (interest and amortization) to disposable income. With the run-up in the stock market and recent rise in home prices, moreover, household net worth is nearing its all-time high.

The housing sector has bottomed, and housing activity is on the rise as reflected in sales of new and existing homes, and rising home prices, which are up by about 7%-8% in the past year. At the same time, there has been a significant decline in the inventory of unsold homes, and new household formation is beginning to rise.

Job growth has improved, with the private sector adding just over 200,000 new workers per month in the last three months. A contributing factor has been an increase in the number of construction jobs. Meanwhile, weekly jobless claims have fallen to their lowest level since the financial crisis.

Corporate profits have staged a remarkable recovery from the lows reached in 2008-09, and are now about 50% above their previous record high. Balance sheet positions are also very strong, with companies sitting on record excess cash.

Financial institutions have also seen their profitability and net interest margins rise significantly, while their balance sheets are in better shape than before the financial crisis. As a result, banks are no longer deleveraging, and bank lending appears poised to rise.

Compared to the private sector, there are still large imbalances in the government sector, owing to a ramp-up in spending during the financial crisis as well as increased transfer payments. During the past two years, however, growth in government spending has slowed considerably, and federal spending is projected to be little changed this year with sequestration in effect. Along with the 2% increase in payroll taxes and the hike in tax rates for the wealthy, the federal budget deficit is projected to decline to about 5% of GDP in 2013, or roughly one half the magnitude during the financial crisis.

Headwinds from "Fiscal Drag"

To be sure, this does not mean the economy is firing on all cylinders. The key to a sustained expansion is a pick-up in consumer spending, which accounts for nearly 70% of aggregate demand. Thus far, personal consumption has been expanding at only a 2% pace, which is too slow to boost the overall growth rate when government spending is being pared back.

A key test for the markets is how consumer spending will hold up when the full effects of the increase in payroll taxes and the implementation of sequestration are felt. During the first two months of this year, consumers responded by drawing down on savings to maintain their spending pace. However, this cannot continue indefinitely. One possibility, therefore, is that consumer spending may slow in the next two quarters. If so, it may cause investors to reassess the economy's prospects and could set the stage for a long-awaited pullback in the stock market.

In that event, however, we believe there are powerful offsets that will sustain the economy and eventually cause it to re-accelerate. They include stronger jobs growth, which will boost disposable income, and improved household net worth, which will help sustain consumer confidence. At the same time, we believe financial institutions will be more willing to extend credit to households and businesses, which should support the expansion. Therefore, we believe any slowdown in consumer spending will prove to be temporary.

Investment Implications

At the beginning of this year, we believed the stock market could test its all-time highs based on our belief the economy was gaining traction. The main surprise for us has been how strong the market has been thus far, when news on the global economy has been mixed. While this could leave the market vulnerable to a pullback, especially if consumer spending were to slow, we are growing more confident that the private sector is gaining traction. If so, the stock market is likely to advance further in the second half of this year. Therefore, we are maintaining an overweight position in favor of U.S. equities in balanced portfolios.

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